Krugman on Ketchup Economics

In a recent piece in The New York Times, columnist and economics professor Paul Krugman schools us on the limitations of neoclassical economics. It’s a great piece, and one of my favorite bits is his reference to “ketchup economics.”

The phrase comes from an observation by Larry Summers — now the top economics adviser in the Obama administration — that the data supporting the rational markets hypothesis focused mainly on whether prices were rational relative to other prices, rather than in the absolute. (The “ketchup” connection will be clear shortly.)

Krugman goes hard after the failure of neoclassical economics to explain bubbles. Here’s a snippet on the hesitation of the neoclassicists to give credence to a housing bubble, painfully close to the collapse.

In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right.

Two thoughts come to mind. First, although it seems quite reasonable that people would be more careful about large transactions such as the sale or purchase of homes, the data are a bit more sobering. Leavitt et al, for example, report that real estate agents selling their own homes enjoy a sales price 3.7% higher than chumps like me, and do it by leaving their houses on the market less than 10 additional days.

And data aside, personal experience seems to indicate — at least in my household — plenty of irrational behavior. For example, costs associated with the purchase (or even sale) seem to get rounded to the nearest $1,000 or so. New linens for a few hundred dollars? No problem – when slinging these big numbers around, a few hundred seem like budget dust.